Tuesday, November 16, 2010

Wasted Capital

President Obama’s recent call for the establishment of a new national infrastructure plan only reinforces my frustration with contemporary American politics.  My frustration arises from the stark realization that we have a political system that virtually assures that in each election, at all levels of government, we are lucky enough to choose between Coke and Pepsi.  When your favorite brand is winning in the polls you tend to forget that product differentiation rules in politics, as efficiently as it determines our choice between California Pizza Kitchen or the Cheesecake Factory for dinner.

Fortunately, I’m not here to rant about politics.  Instead, I’ll offer a critique of the economic merit behind the President’s transportation proposal.  Before we get too far I’d like to disclaim that I fully support the rapid expansion of modern transportation infrastructure in the US.  We badly need to both repair our current stock of aging infrastructure and invest in infrastructure that offers real choice in transcontinental travel.  Every day that passes without a high-speed rail system in this country is another opportunity for the airline industry to find new, innovative ways to suck the life out of America.  For example, this “saddle” seat might become the new coach class standard if the FAA approves them as safe for implementation.  The airport experience is already dehumanizing enough with the TSA’s “freedom-enhancing” procedures; further cost saving innovations on the part of the airline oligopoly need not offer the icing on the cake.

I don’t object to Federal investment in transportation infrastructure, only the level and method of financing.  On Labor Day, Obama called for Congress to front-load $50 B in seed money for the establishment of an “infrastructure bank” that will fund future transportation projects.  This new bank will nest under the Department of the Treasury and will function as a public-private partnership.  According to Michael Hudson, the initial seed money will provide the necessary incentive to invite a flow of funds from the investment houses in Wall Street to the infrastructure bank, thus allowing the private sector the “opportunity” to rebuild America.  The public side of the “partnership” enters into the equation in the event the bank goes insolvent.  Therefore, the usual risk associated with massive, public-works projects - the sort of risk that prices the entrepreneur out of such enterprise - is reduced to a level consistent with a firms profit expectations.
When private capital serves as the source of finance for investment, the resultant assets - highways, railroads, streetcars, etc. - are expected to yield a stream of payments over their lifetime.  In the case of infrastructure, revenue takes the form of user fees - tolls, taxes, fares, etc.  Prima facie, user fees seem like a fair method of spreading the burden of public finance amongst those who benefit the most from its service.  After all shouldn’t those that choose to use the infrastructure pay for its cost?  Wait to answer that question until you’ve considered that we are dealing with private ownership of a natural monopoly, which in the absence of a functional and effective regulatory framework results in the user being taxed with monopoly prices.  Before it fades from our collective memory, with a little help of revisionist history, let us recall the price people paid for their natural monopoly services from the likes of Enron, Vivendi and Bechtel.  Corporations are only beholden to their shareholders managers; there’s no guarantee that monopoly profits will translate into expenditures on maintenance and investment.
Hudson points to the likelihood that property values will increase as a result of the “right-of-way” implied by new transportation infrastructure.  The increase can be thought of as a windfall capital gain that accrues to those that hold land along the new or modified route.  In addition to user fees, the difference between the ex ante / ex post land value provides yet another opportunity for Wall Street to reap private gains from public activity.

To anticipate the reader’s thoughtful counter-critique:  “Sure, we all hate Wall Street, but what choice do we have?  We need to do something about our aging infrastructure, we need to promote greener transportation solutions, and we need more jobs!  Since we can’t continue to borrow money from the Chinese that our grandchildren will have repay, relying on private investors to fund these programs is sound finance.”  Before we can move the discourse over policy questions of this nature, we need to settle a few fallacies, which serve as hurdles to a sensible understanding of the problems of the day.

First, the notion that we have to make tough choices between borrowing from the Chinese and saddling future generations with debt, or foregoing the subsequent investment from deficit financing and living with unemployment is a false choice fallacy.  The fallacy is constructed by presenting two possible choices, each diametrically opposed to the other, and suggesting that a choice must be made.  The fallacy is exposed once we consider that not only is there a range of possible choices beyond the ones presented, but that the original options are themselves misleading.  For instance, deficit financing operates as the Treasury issues bonds for sale to the financial system, most notably the Federal Reserve.  Since there is no limit to the amount of T-bills the central bank may purchase from the Treasury, because there is no cash constraint, then it makes no sense to say that China’s willingness to purchase those bonds limits the ability to engage in deficit finance in the future.  If the US wants to issue bonds the central bank will accommodate.  While the Chinese may prefer to hold reserves in US bonds it is important to note that those bonds are denominated in dollars, not RMB, so the likelihood of default approaches zero.  Furthermore, bond issue is not the only way to engage in deficit spending.  The Treasury may simply credit the bank accounts of those it wishes to contract from.  However, that is a wholly separate discussion on public finance which demands its own forum.  For our purposes here, let’s just assume the government needs to sell bonds to raise money for its purchases.  For those curious about that process, there has been a thorough treatment here, here, here and here.

This leads nicely into my second point that the popular media, and so the conventional wisdom, consistently mistakes budgetary for economic costs.  Almost daily we are reminded of the dollar cost of the bailout, health-insurance reform, the social security trust fund, and a host of other “wasteful” entitlement packages.  These figures, in total, measure in the trillions and when subject to compound growth present an untenable future for the US economy.  The misconception lies in the complete absence of any mention of economic costs and benefits associated with such policy.  For example, when Paul Volcker refers to returning to an era of “sound finance” he speaks of a balanced budget economy.  All current tax receipts should offset all current outlays.  Or better, tax receipts should exceed outlays in the current period until such time that the deficit approaches zero.  Yet, when we are in the midst of rather severe recession, characterized by high and persistent unemployment, the economic costs of lost output dwarfs the nominal benefit of paying down the deficit.  The result is that the future is far less productive than its potential, thereby reducing growth and income for our future generations.  In this sense, “sound finance” is nothing but a “beggar thyself” policy.
At this point the chorus usually rings, “Bah, Keynesians believe you can get something for nothing.  You can have your cake and eat it too!  Every sensible businessman knows that only through parsimony, gumption, and a little luck does wealth accrue!”  But, businessmen know well that investing during a period of slack demand and rampant joblessness is a quick way to go broke.  Consider this statement from the Chief Economist at Goldman-Sachs:

“One important reason why we expect the economy to remain weak is that the household sector is likely to deleverage its balance sheet further. This will require households and the private sector more broadly to run a large financial surplus, which will keep demand weak unless offset by substantial fiscal (and monetary) stimulus…..The still-high ratios of debt and debt service to disposable income suggest that the household sector and the private sector more broadly will need to continue running financial surpluses in coming years. Unless fiscal and monetary policy provide a strong counterweight, this is likely to imply only sluggish growth, with risks tilted to the downside.” (zero hedge) via Mike Whitney at Counter Punch

So households aren’t spending because they’re paying down debt and saving, in anticipation that things aren’t going to get better anytime soon.  Let’s help “lull their disquietude” by announcing a revised plan to hire every unemployed person willing to work, to build a network of 21st century infrastructure, and to complete the project within ten years.  We can do this without paying Wall Street a dividend; without wasting real and political capital.  We can do this right now.

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